Meaning of trading on equity – Equity means equity capital or capital of the owners, whereas trading means earning of profits. In composite form, the method of earning profits by equity capital is known as trading on equity.
In a narrow sense, when trading in any business institution is done on the basis of debt capital, rather than equity capital, then it is known as trading on equity.
However, in a broader sense, when the managers/directors of any company depend upon debt or debentures or issue of preference shares to fulfill the financial requirements of the company, aiming at earning maximum profits on equity shares held by them, it is known as trading on equity.
When a person or a corporation uses debt capital with owned capital in the regular conduct of its business, then it is said to be trading on equity.
Thus, the meaning of trading on equity is the technique, by which an attempt is made to earn more income on equity capital getting capital through fixed cost securities.
Objectives of Trading on Equity
The main object of trading on equity is to operate own trade regularly by collecting debt capital also, along with the owner’s capital.
Other broad objectives are as follows:
- To increase the rate of dividends for equity shareholders.
- To acquire control on financial sources, by taking maximum possible Debt, support of minimum ownership capital.
- To enhance the reputation of the institution by increasing the market price of equity share.
- To concentrate trade in own hands.
Related: Capital Gearing: Types, Importance, Advantages and Effects.
Types of Trading on Equity
Trading on equity is of two types:
1. Trending on Low or Tiny Equity
When the quantity of share capital of the company is less than the debt capital than that situation is known as trading on Low or thin equity.
In other words, when the share of fixed cost securities (Debt, Debentures or Preference shares) is more than equity capital, it is said that the company is trading on low or thin equity.
2. Trading on High or Thick Equity
When the share capital of the company is more than the debt capital, that situation is known as trading on high or thick equity.
In other words, when a company collects more funds from equity shares and less by the fixed cost securities, then it is said that the company is trading on high or thick equity.
Importance or Advantages of Trading on Equity
Following are the advantages or importance of trading on equity to the company and its several parties:
1. Continuous Operation of Trading
The most important advantages of trading on equity to the company are that its trade operates quite regularly, because the company also Rises the debt capital, along with ownership capital.
2. Payment of Dividend on High Rate
The company may increase its income by using the policy of trading on equity and may make payment of dividend at a higher rate on the equity capital.
As a result, the income of shareholders also increases.
Related: 11 Key Features and Importance Cost of Capital.
3. Minimize Tax Burden
The tax burden on the company gets minimized, by trading on equity, because the tax is levied only on profits accruing after payment of interest on loans and debentures.
4. Increase in Goodwill of Company
Since as a result of trading on equity, the dividend is paid at high rates, it has good effects on the Goodwill of the company, as well.
With the increase in Goodwill of the company, the per-share price of the company also goes high.
As a result, the company is able to easily obtain loans from the market and owners of the company become capable to expand their trade with the help of Debt capital.
5. Control on Financial Sources
The company may gain control over maximum financial sources, even with the investment of very low capital, by using the policy of trading on equity.
6. Control on Business
By trading on equity, the promoters or establishers of the business may exercise control on the business, because if the quantity of equity capital gets reduced, then it is issued to a small group.
As a result, the voting power gets centralized in the hands of a small group and control over the business may be gained, easily.
Limitations of Trading on Equity
Along with various advantages of a policy of trading on equity, it has some limitations or disadvantages also, which are as follows:
1. Uncertainty of Income
The policy of trading on equity may be profitable only when the income of the business has certainty, stability, and continuity.
If income does not remain stable and regular, and in any year either the profits are low or losses are incurred, then the shareholders will get nothing and interest payment to debenture holders will also become different.
Related: 18 Major Factors Affecting Capital Structure (Complete List).
2. Low Rate of Return
When the rate of return received on invested capital goes on decreasing and rate of return becomes even lower than the rate of interest and rate of preference dividend, then the company is not in a position to carry out trading on equity.
Hence, the company will get deprived of the benefits of trading on equity on a reduction in the rate of return.
3. Limitations Relating to Management Support
If the financial position of the company is so good that it may arrange funds by issuing debentures or mortgage deeds and this debt capital is economical, in comparison to the share capital.
Even then, its management may decline to support this policy.
4. Loan on High Rate of Interest
The rate of interest on the amount taken on loan gradually goes on rising, as a result of the policy of trading on equity, because every fresh loan increases the risks.
Hence, the investor taking high risks wants its reward also.
As a result, the company has to reduce the rate of the dividend of the shareholders.
5. Legal and Contractual Difficulties
Many times, trading on equity is beneficial.
But, obstacles arise in taking loans, due to restrictions by the existing legal provisions, like – Company act, and other Nation act, and also according to the contract.
6. Fear of Over Capitalization
Trading on equity is operated on the strength of debt, but it may be the to a certain limit only, reason being that due to interest not decided rates the burden of expenses on the company becomes so heavy that after some time, the business becomes overcapitalization.
It reduces the loan taking capacity of the company and the market value of the shares also starts declining due to a reduction in the rate of dividends.
7. Under Intervention of Loan Givers
Besides other economic reasons the influence and intervention of the loan givers increases, while adopting the policy of “Trading on Equity“.
In such a situation, whenever the need for additional capital arises, the business faces difficulty because each such scheme of increasing the capital requires the approval of the loan givers.
8. Difficulty in Extra Capital
If the activities of the company are directed by Finance Corporation, Industrial Development Bank, and other specific financial institutions, then such Institutions may even limit the maximum amount of loan which may be taken by the company and may stop the issue of next debentures and Mortgage Loans.
Limitations of Debt
Now, the question arises, to what extent debt should be availed by the management to take profit of trading and increasing the utility.
In response, it may be said that the debt capital should be used until the additional income generated by Debt capital is more than the cost of the debt capital.
When the additional cost and additional income are equal, that is the maximum limit of the debt capital.
At this level, Earning per share (EPS) will always be the same, irrespective of the debt-equity mix.
Related: 15 Essential Features of Venture Capital (in Simple Words).
This is known as the abstract point of earning before tax and interest (EBIT).
Abstract point is that point where the rate of return on investment of debt capital is equal to the rate of interest of this capital.
If the probable income of the companies is much above this point, It will be beneficial to arrange funds through the debentures.
On the contrary, if the income is expected to be less than this point, The use of equity share capital will be beneficial, because in such conditions, Earning per share will be high.
If the expected income is less than even the fixed costs, the company will incur losses.
In addition to it, the use of equity shares will also not prove useful for the company and hence, the closer of the business will be worthwhile, keeping in view of safeguarding the interests of the owners.
Thus, the best form of the capital structure may be determined with the help of abstract point analysis.
Following are the important points regarding trading on equity:
- Trading on equity is a technique to earn profits.
- Inequity capital, the amount of both equity shares and free reserves and Debt capital are included.
- The proportion of debt capital is higher in it, as compared to owners’ capital.
- Operation of own regular trade is done in it by taking the capital, along with owners’ capital.
- This policy is adopted only when the owners feel confident on the basis of certain and sufficient Grounds that the amount of interest payable on loans was taken will be less than the income to accrue on account of the Debt capital.
Thus, now you know the ultimate guide to trading on equity.
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In this financial leverage ,the company is betting that the return from the investment will generate more income than it costs to finance the investment.
Equity plays a major role in finance with various benefits and the major one is freedom of debt